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Chapter 11

Example 6

Alpha Co has a P/E ratio of 16 and post-tax earnings of $200,000. Beta Co
has a P/E ratio of 21 and post-tax earnings of $800,000.

Beta's directors estimate that if they were to acquire Alpha they could save
$100,000 (after tax) annually on administrative costs in running the new
combined company. Additionally they estimate that the P/E ratio of the new
company would be 20.

On the basis of these estimates, what is the maximum that Beta should
pay for the entire share capital of Alpha?

A $6.3 million

B $5.2 million

C $4.2 million

D $2.0 million

Solution

The answer is (B).

Expected value of Alpha and Beta combined is:

20 × (200,000 + 800,000 + 100,000) = $22 million

Beta's current value is 21 × 800,000 = $16.8 million.

Therefore the value of Alpha to Beta is the difference between these two
figures, i.e. $5.2 million.

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